Monthly Commentaries

Throwing the baby out with the bath water – September, 2011

Equity markets marked their worst quarter in more than two years. The European indexes fell 23%, while the U.S. and Canadian markets dropped 7% and 12%, respectively. Meanwhile, bond yields dropped to levels that, just a few months ago, were unimaginable. Currently, 10-year U.S. government bonds yield a miniscule 1.80%. Much of the market pressure was caused by news from Europe. How the European community dealt with a potential Greek default determined the stock market direction. It moved up on any sliver of good news and fell when government officials commented on the state of the market. This is the type of market where disciplined security selection adds value. Institutions and individuals alike are using Exchange Traded Funds (ETFs) to alter the asset allocation in their portfolios such as selling European investments to buy bonds. The most actively traded ETFs are exactly the same in composition as the stock indexes. Therefore, when a Euro Stoxx index ETF is sold, it is the same as selling a piece of every stock on the European exchange. The factors that drive the profitability in any one company are not relevant. People trade the ETF as if it represents a giant stock called Europe Incorporated.

Even when you listen to their comments, you hear something along the lines of "we are reducing European exposure". It means the stocks with good fundamentals are also dragged down with those with questionable financial prospects, thus throwing the baby out with the bath water. In this environment of indiscriminate selling, managers like us see opportunity. As most of you may be aware, Toron focuses not on where the company is domiciled but where the corporations generate their revenues. For example, a company like Unilever only earns about 30% of its sales from Europe, while a full 70% of its revenue comes from the rest of the world. However, in this environment as the "Sell Europe" mentality takes hold, a stock like Unilever is sold with little regard to its fundamentals. For investors, when you focus on the stocks rather than the broad market moves, it often suggests a buying opportunity.

European equities are currently priced at valuation levels we have not seen in some time. Indeed, many equities are priced not for a slowdown but for a significant recession. It is buying or staying with equities in this type of environment that is most difficult. However, by focusing on the fundamentals of the companies rather than getting carried away by emotion and news flow, investors can be successful. It is at times like this that one has to avoid the urge to sell their investments for the perceived safety of bonds that, at best, will yield 1.80%. Instead, focus on the stocks and their resulting dividend payments that in many cases yield much more than government bonds. Arthur Heinmaa, CFA Managing Partner